7. Analysis of published financial statements

Question 1

What is meant by stewardship accounting?

Answer 1

Stewardship refers to the traditional approach of accounting under which the
owners of a business (the shareholders) entrust the management in managing
business. Shareholders entrust the board of directors with the responsibility
for managing the resources entrusted to them by giving it direction and
providing both control and strategy. The board employs managers to implement
their strategic vision and to and maximise the returns of the wealth of the
shareholders. An obligation of stewards or agents, such as directors, is to
provide relevant and reliable financial information relating to resources over
which they have control, but which are owned by others.

Question 2

Who are the interested parties and how do they benefit from the analysis of financial statements?

Answer 2

Different parties are interested in financial statements and their analysis for
various reasons. These parties include investors, management, employees,
lenders, suppliers, trade creditors, tax authorities, government and their
agencies, researchers and stock exchanges.
Financial statements are prepared for decision-making purposes, which is driven
by effective analysis and interpretation of financial statements. Financial analysis
indicates the profitability and financial soundness of a business entity for a given
period. It determines its financial strengths and weaknesses by assessing the
efficiency and performance of an entity. Key measures include:
‹ evaluation of profitability
‹ financial trends of achievements
‹ growth potential
‹ comparative position in relation to similar businesses
‹ assessment of overall financial strength
‹ assessment of solvency

Question 3

Where are the key objectives of fundamental analysis and its components?

Answer 3

Fundamental analysis is a systematic approach to evaluating company
performance based on historical data. The end goal of this analysis is to
generate an insight about the company’s future performance and business
forecast.
It is also used:
‹ to derive the valuation of the company
‹ to evaluate the performance of the company management and conduct
internal audit of its business decisions
‹ to determine the intrinsic value of the share or the company’s intrinsic
value and its growth prospects

The components of fundamental analysis are:
‹ economic analysis, including analysis of:
– GDP
– interest rates
– employment
– foreign exchange
– manufacturing
‹ industry analysis, including analysis of:
– competitors
– industry lifecycle
– Porter’s five forces
‹ company analysis, including analysis of:
– business assets
– liabilities
– earnings

Question 4

What are the profitability and return ratios?

Answer 4

Return Ratios:
1. Return on Capital Employed
2. Return on Total assets
3. Return on Shareholders’ Equity
Margin Ratios:
4. Gross Profit Margin
5. Operating Profit Margin
6. Net Profit Margin

Question 5

What are the efficiency (or turnover) ratios

Answer 5

Asset turnover
Inventories turnover
Inventory holding period
Rate of collection of trade receivable
Rate of payment of trade payables
Working capital cycles

Question 6

Liquidity ratios?

Answer 6

Current ratio
CR=CA/CL
Liquid ratio=CA-Inventory/CL

Question 7

Efficiency ratios

Question 8

Gearing ratios

Answer 8

The Gearing Ratios are of two types:
Financial Gearing - based on
Statement of Financial Position
(Equity or Capital Gearing)
Operating Gearing - based on
Statement of Profit or Loss

Question 9

Chapter summary

Answer 9

Financial statements are prepared to aid decision making, which is underpinned by effective analysis and interpretation of financial statements. Financial analysis draws meaningful relationships between items on the two financial statements:
– the statement of profit or loss and OCI (or income statement)
– the statement of financial position (or balance sheet)

‹ They are the indicators of profitability and financial soundness of a business entity for a given period.

‹ The purpose of financial analysis is to assess the financial strength and weaknesses of a company by assessing its efficiency and performance. The key measures in determining the financial strength of a company are:
– profitability
– trend of achievements
– growth potential of the company
– comparative position in relation to similar company’s or businesses
– overall financial strength and solvency of the company

‹ The analysis and interpretation of financial statements assesses the financial strengths and weaknesses of a company. The key measures used are:
– fundamental analysis: economic analysis, industry analysis and company analysis;
– trend analysis: vertical analysis and horizontal analysis; and
– ratio analysis: profitability ratios, asset efficiency or turnover ratios, liquidity or solvency ratios, gearing or debt ratios and investment or market value ratios.

‹ Fundamental analysis is a systematic approach to evaluating company performance based on the analysis of its financial statements. It is an in-depth study of underlying forces that drive a company’s performance which considers the overall state of the economy in which a company operates, the industry which it belongs to and factors including interest rates, production, earnings, employment, GDP and so on. Fundamental analysis includes:
– economic analysis: different companies/industries perform
differently during the different stages of an economic cycle;
– industry analysis: based on the four stages of the industry lifecycle;
and
– company analysis: evaluating information relating to the company’s
profile, products and services as well as its profitability and financial
position.

‹ Trend analysis is the process of analysing financial data to identify any consistent results or trends. The trend can be:
– horizontal: comparing line items in a company’s financial statements
or financial ratios over multiple reporting periods; or
– vertical: the proportional analysis of line items as a percentage of base
items.

‹ Ratio analysis provides businesses owners with trend or time-series analysis
and trends within their industry, called industry or cross-sectional analysis.

‹ Profitability ratios measure the capability of the company to generate profit compared to revenue, expenses, assets and shareholders’ equity.

It indicates the effectiveness of the capital invested and asset utilisation.
These ratios are broadly divided into two categories:
– margin ratios: these represent a company’s ability to convert sales
into profits and include the gross profit margin ratio, the operating
margin ratio and the net profit margin ratio; and
– return ratios: these represent a company’s ability to generate returns
to its shareholders and include the ROA ratio, the ROE ratio and the
ROCE ratio.

‹ While ratio analysis is useful, it has its limitations. For example, mere
percentages may not reflect a holistic picture about a situation, trends
are a reflection of historical performance and do not consider inflation
or seasonal factors, or window dressing which may be manipulating the
financial statements.

‹ International Standard on Auditing 240 (the Auditor’s Responsibilities
Relating to Fraud in an Audit of Financial Statements) recognises that
misstatement in the financial statements can arise from either fraud or
error (unintentional misstatement).

‹ Fraud can be further split into two types: fraudulent financial reporting
(intentional misstatement) and misappropriation of assets (theft).

‹ Creative accounting is the deliberate manipulation of figures for a desired
result. This occurs due to inherent weaknesses in accounting systems,
accounting choices, accounting judgment and accounting transactions. A
number of creative accounting measures are aimed at manipulating the
numbers, but regulation is increasingly catching up.